CHAPTER 24 PERFORMANCE EVALUATION FOR DECENTRALIZED OPERATIONS DISCUSSION QUESTIONS In a centralized operation, all major planning and operating decisions are made by top management In a decentralized operation, managers of separate divisions or units are delegated operating responsibility The division (unit) managers are responsible for planning and controlling the operations of their divisions Divisions are often structured around products, customers, or regions The department manager of a profit center has responsibility for and authority over costs and revenues, while the manager of an investment center has responsibility for and authority over controlling investments in assets as well as costs and revenues Payroll: Number of checks issued Accounts payable: Number of invoices paid Accounts receivable: Number of sales invoice payments collected Database administration: Number of reports generated The major shortcoming of using income from operations as a measure of investment center performance is that it ignores the amount of investment committed to each center Since investment center managers also control the amount of assets invested in their centers, they should be held accountable for the use of invested assets A division of a decentralized company could be considered the least profitable, even though it earned the largest amount of income from operations, when its rate of return on investment is the lowest In this situation, the division would be considered the least profitable per dollar invested in the division because it generated less profit out of each dollar of assets invested By dividing income from operations by the amount of invested assets, each division is placed on a comparable basis of income from operations per dollar invested The balanced scorecard attempts to identify the underlying nonfinancial drivers, or causes, of financial performance related to innovation and learning, customer service, and internal processes In this way, the financial performance may be improved For example, customer satisfaction is often measured by the number of repeat customers By increasing the number of repeat customers, sales and income from operations can be increased The objective of transfer pricing is to encourage each division manager to work in the best interests of the company Thus, transfer prices should encourage managers to transfer goods between divisions if the overall company income can be increased When unused capacity exists in the supplying division, the negotiated price approach is preferred over the market price approach 10 When using the negotiated price approach to transfer pricing, the transfer price should be less than the market price but greater than the supplying division’s variable cost per unit 24-1 © 2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part CHAPTER 24 Performance Evaluation for Decentralized Operations PRACTICE EXERCISES PE 24–1A $326,000 over budget ($252,000 + $74,000) PE 24–1B $250,000 under budget ($198,000 + $52,000) PE 24–2A Northeast Division Service Charge for Travel Department: $195,750 = 1,800 billed reservations ì ($435,000 ữ 4,000 reservations) Pacific Division Service Charge for Travel Department: $239,250 = 2,200 billed reservations × ($435,000 ÷ 4,000 reservations) PE 24–2B Retail Division Service Charge for Computer Technology Department: $118,800 = 1,125 billed hours × ($264,000 ÷ 2,500 hours billed) Commercial Division Service Charge for Computer Technology Department: $145,200 = 1,375 billed hours × ($264,000 ÷ 2,500 hours billed) PE 24–3A Sales……………………………………………………… Cost of goods sold…………………………………… Gross profit…………………………………………… Selling expenses……………………………………… Income from operations before service department charges………………………………… Service department charges………………………… Income from operations……………………………… Northeast Pacific Division Division $1,155,000 590,800 $1,204,000 658,000 $ 564,200 231,000 $ 546,000 252,000 $ 333,200 195,750 $ 294,000 239,250 $ 137,450 $ 54,750 PE 24–3B Sales……………………………………………………… Cost of goods sold…………………………………… Gross profit…………………………………………… Selling expenses……………………………………… Income from operations before service department charges………………………………… Service department charges………………………… Income from operations……………………………… Retail Commercial Division Division $945,000 504,000 $966,000 559,300 $441,000 156,800 $406,700 175,000 $284,200 118,800 $231,700 145,200 $165,400 $ 86,500 PE 24–4A a b c Profit Margin = $96,000 ÷ $1,200,000 = 8.0% Investment Turnover = $1,200,000 ÷ $400,000 = 3.0 Rate of Return on Investment = 8.0% × 3.0 = 24% PE 24–4B a b c Profit Margin = $36,000 ÷ $720,000 = 5.0% Investment Turnover = $720,000 ÷ $180,000 = 4.0 Rate of Return on Investment = 5.0% × 4.0 = 20% PE 24–5A Income from operations…………………………………………………………………… Less: Minimum acceptable income from operations as a percent of assets ($450,000 × 10%)…………………………………………………… Residual income…………………………………………………………………………… $90,000 45,000 $45,000 PE 24–5B Income from operations…………………………………………………………………… Less: Minimum acceptable income from operations as a percent of assets ($910,000 × 8%)……………………………………………………… Residual income…………………………………………………………………………… $420,000 72,800 $347,200 PE 24–6A Increase in South (Supplying) Division’s Income from Operations (Transfer Price – Variable Cost per Unit) = × Units Transferred ($52 – $42) × 30,000 units = $300,000 Increase in South (Supplying) Division’s Income from Operations Increase in North (Purchasing) Division’s Income from Operations Increase in North (Purchasing) Division’s Income from Operations = (Market Price – Transfer Price) = × Units Transferred = ($60 – $52) × 30,000 units = $240,000 PE 24–6B Increase in Pembroke (Supplying) Division’s Income from Operations = ($82 – $75) × 15,000 units = $105,000 Increase in Pembroke (Supplying) Division’s Income from Operations Increase in Multinomah (Purchasing) Division’s Income from Operations Increase in Multinomah (Purchasing) Division’s Income from Operations (Transfer Price – Variable Cost per Unit) × Units Transferred = (Market Price – Transfer Price) = × Units Transferred = ($90 – $82) × 15,000 units = $120,000 EXERCISES Ex 24–1 a (a) (b) (c) (d) (e) (f) $192,240 $195,072 $2,832 $592,056 $596,256 $4,848 (g) (h) (i) (j) (k) (l) $592,056 $596,256 $4,200 $1,876,536 $1,876,056 $4,200 Schedules of supporting calculations (answers in italics; the solution requires working from the department level, up to the plant level, then to the vice president of production level): MAQUIRE COMPANY Budget Performance Report—Vice President, Production For the Month Ended May 31, 2014 Plant Budget Mid-Atlantic Region West Region South Region $ 748,800 535,680 592,056 (g) $1,876,536 (j) Actual $ 747,000 532,800 596,256 (h) $1,876,056 (k) Over Budget Under Budget $1,800 2,880 $4,200 (i) $4,200 (l) $4,680 MAQUIRE COMPANY Budget Performance Report—Manager, South Region Plant For the Month Ended May 31, 2014 Department Chip Fabrication Electronic Assembly Final Assembly Budget Actual Over Budget $192,240 (a) 153,216 246,600 $195,072 (b) 155,232 245,952 $2,832 (c) 2,016 $592,056 (d) $596,256 (e) $4,848 (f) Under Budget $648 $648 Ex 24–1 (Concluded) MAQUIRE COMPANY Budget Performance Report—Supervisor, Chip Fabrication For the Month Ended May 31, 2014 Cost Budget Factory wages Materials Power and light Maintenance b $ 47,952 125,280 6,912 12,096 $192,240 Actual $ 49,200 124,416 8,208 13,248 $195,072 Over Budget Under Budget $1,248 $864 1,296 1,152 $3,696 $864 MEMO To: Holly Keller, Vice President of Production The South Region plant has experienced a budget overrun, while the Mid-Atlantic and West Region plants have experienced a budget surplus The budget of the South Region plant reveals that the Chip Fabrication Department causes the majority of the budget overrun The budget for the Chip Fabrication Department indicates that the budget overrun was caused by a combination of budget overruns in wages, power and light, and maintenance that exceeded a budget surplus in materials The supervisor of the Chip Fabrication Department should investigate the reasons for the budget overruns in wages, power and light, and maintenance It is possible that all three of these budget overruns have the same cause, such as a need for unplanned overtime or weekend work to meet schedules Ex 24–2 ENDLESS RIVER CONSTRUCTION COMPANY Divisional Income Statements For the Year Ended June 30, 2014 Commercial Residential Division Division Net sales Cost of goods sold $1,083,600 732,200 $595,000 338,940 Gross profit Administrative expenses $ 351,400 119,840 $256,060 102,900 $ 231,560 90,048 $ 141,512 $153,160 54,264 $ 98,896 Income from operations before service department charges Service department charges Income from operations Ex 24–3 Expense Activity Bases a b c Legal Duplication services Electronic data processing d e f Central purchasing Telecommunications Accounts receivable Number of hours Number of pages Central processing unit (CPU) time, number of printed pages, amount of memory usage Number of requisitions, number of purchase orders Number of lines, number of minutes Number of invoices, number of customers Ex 24–4 a b c d e f g h Ex 24–5 a Number of payroll checks: Weekly payroll × 52………… Monthly payroll × 12……… Total……………………… Number of purchase requisitions per year………… Residential Commercial Government Contract 13,000 600 6,500 1,200 7,800 720 13,600 7,700 8,520 29,820 3,750 3,125 2,750 9,625 Service Dept Cost Activity Base b Service department charge rates: Payroll Department……………………… $119,280 Purchasing Department…………………… $57,750 Residential Service department charges: Payroll Department………… $54,400 Purchasing Department…… 22,500 $76,900 Total……………………… 13,600 checks × $4.00 per check 7,700 checks × $4.00 per check 8,520 checks × $4.00 per check 3,750 requisitions × $6.00 per requisition 3,125 requisitions × $6.00 per requisition 2,750 requisitions ì $6.00 per requisition ữ ữ Commercial $30,800 ữ = 29,820 9,625 $34,080 Charge Rate = $4.00/check = $6.00/req Government Contract 18,750 $49,550 Total 16,500 $50,580 Total $119,280 57,750 The service department charges are determined by multiplying the service department charge rate by the activity base for each division c Residential’s service department charge is higher than the other two divisions because Residential is a heavy user of service department services Residential has many employees on a weekly payroll, which translates into a larger number of check-issuing transactions This may be because residential jobs are less productive per labor hour, compared to larger commercial and government contract jobs Additionally, Residential uses purchasing services more than the other two divisions This may be because the division has many different smaller jobs requiring frequent purchase transactions Ex 24–6 a Help desk: Network center: $735,000 9,800 devices Electronic mail: $100,000 10,000 accounts Local voice support: b $160,000 3,200 calls = $50 per call = $75 per device monitored = $10 per user or e-mail account $124,600 = $14 per phone extension 8,900 phone extensions October charges to the COMM sector: Help desk charge: (5,200 employees × 25% × 96% × 1.5) × $50/call = $93,600 Network center charge: [(5,200 employees × 25% × 96%) + 600] × $75/device = $138,600 Electronic mail: (5,200 employees × 25% × 96% × 100%) × $10/user or e-mail account = $12,480 Local voice support: (5,200 employees × 25%) × $14/phone extension = $18,200 Ex 24–7 VAN EMBURGH TECHNOLOGY Divisional Income Statements For the Year Ended December 31, 2014 Consumer Division Commercial Division Revenues Cost of goods sold $5,944,000 3,298,400 $4,947,200 2,500,000 Gross profit Operating expenses $2,645,600 1,172,000 $2,447,200 1,236,800 $1,473,600 $1,210,400 Income from operations before service department charges Less service department charges: Tech Support Department (Note 1) Accounts Payable Department (Note 2) Income from operations $422,500 87,040 $253,500 509,540 $ 964,060 168,960 422,460 $ 787,940 Supporting calculations for controllable service department charges: Note 1: Consumer Division ($676,000 ữ 400 computers) ì 250 computers = $422,500 Commercial Division ($676,000 ÷ 400 computers) × 150 computers = $253,500 Note 2: Consumer Division ($256,000 ÷ 10,000 checks) × 3,400 checks = $87,040 Commercial Division ($256,000 ữ 10,000 checks) ì 6,600 checks = $168,960 Prob 24–3B THE WHOLE EARTH FOOD COMPANY Divisional Income Statements For the Year Ended June 30, 2014 Cereal Snack Cake Retail Bakeries Division Division Division Sales Cost of goods sold $12,000,000 8,000,000 $6,600,000 4,600,000 $5,740,000 4,000,000 Gross profit Operating expenses $ 4,000,000 3,280,000 $ 720,000 $2,000,000 1,340,000 $ 660,000 $1,740,000 1,051,200 $ 688,800 Income from operations Rate of Return = Profit Margin × Investment Turnover on Investment Rate of Return = on Investment Cereal Division: ROI = Income from Operations Sales $720,000 × $12,000,000 $12,000,000 $6,000,000 ROI = 6% × 2.0 ROI = 12.0% Snack Cake Division: ROI = $660,000 × $6,600,000 $6,600,000 $4,400,000 ROI = 10% × 1.5 ROI = 15.0% Retail Bakeries Division: $688,800 ROI = $5,740,000 ROI = 12% × 1.4 ROI = 16.8% × $5,740,000 $4,100,000 × Sales Invested Assets Prob 24–3B (Concluded) Per dollar of invested assets, the Retail Bakeries Division is the most profitable of the three divisions Assuming that the rates of return on investments not change in the future, an expansion of the Retail Bakeries Division will return 16.8 cents (16.8%) on each dollar of invested assets, while the Cereal and Snack Cake divisions will return only 12 cents (12%) and 15 cents (15%), respectively Thus, when faced with limited funds for expansion, management should consider an expansion of the Retail Bakeries Division first Prob 24–4B Rate of Return = Profit Margin × Investment Turnover on Investment Rate of Return = on Investment Electronics Division: ROI = Income from Operations Sales $126,000 $1,575,000 × × Sales Invested Assets $1,575,000 $1,050,000 ROI = 8.0% × 1.5 ROI = 12% GIHLBI INDUSTRIES INC.—ELECTRONICS DIVISION Estimated Income Statements For the Year Ended December 31, 2014 Proposal Proposal Proposal 3 Sales Cost of goods sold $1,575,000 859,600 $1,395,000 771,450 $1,575,000 702,000 Gross profit Operating expenses Income from operations $ 715,400 558,000 $ 157,400 $ 623,550 498,000 $ 125,550 $ 873,000 558,000 $ 315,000 Invested assets $ 750,000 $ 937,500 $1,968,750 $891,000 – $31,400 $1,050,000 – $300,000 $1,575,000 – $180,000 $891,000 – $119,550 $558,000 – $60,000 $1,050,000 – $112,500 $891,000 – $189,000 $1,050,000 + $918,750 CHAPTER 24 Performance Evaluation for Decentralized Operations Prob 24–4B (Concluded) Rate of Return on Investment = Profit Margin × Investment Turnover Rate of Return = on Investment Proposal 1: Income from Operations Sales ROI = $157,400 × $1,575,000 × Sales Invested Assets $1,575,000 $750,000 ROI = 10.0% × 2.1 ROI = 21.0% Proposal 2: ROI = $125,550 × $1,395,000 $1,395,000 $937,500 ROI = 9.0% × 1.5 ROI = 13.5% Proposal 3: ROI = $315,000 $1,575,000 × $1,575,000 $1,968,750 ROI = 20.0% × 0.8 ROI = 16.0% Proposal would yield a rate of return on investment of 21.0% Rate of Return = Profit Margin × Required Investment Turnover on Investment 20% = 8% × Required Investment Turnover Required Investment = 2.5 (20% ÷ 8%) rounded Turnover Current Investment = 1.5 Turnover Increase in = Investment Turnover or 66.7% Increase (1.0 ÷ 1.5) 1.0 Prob 24–5B FREE RIDE BIKE COMPANY Divisional Income Statements For the Year Ended December 31, 2014 Road Bike Mountain Bike Division Division Sales Cost of goods sold $1,728,000 1,380,000 $1,760,000 1,400,000 Gross profit Operating expenses $ 348,000 175,200 $ 172,800 $ 360,000 236,800 $ 123,200 Income from operations Rate of Return = Profit Margin × Investment Turnover on Investment Rate of Return = on Investment Road Bike Division: ROI = Income from Operations Sales $172,800 × $1,728,000 $1,728,000 $1,440,000 ROI = 10.0% × 1.20 ROI = 12.0% Mountain Bike Division: ROI = $123,200 $1,760,000 × $1,760,000 $800,000 ROI = 7.0% × 2.20 ROI = 15.4% Road Bike Division: $28,800 [$172,800 – ($1,440,000 × 10%)] Mountain Bike Division: $43,200 [$123,200 – ($800,000 × 10%)] × Sales Invested Assets Prob 24–5B (Concluded) On the basis of income from operations, the Road Bike Division generated $49,600 ($172,800 – $123,200) more income from operations than did the Mountain Bike Division However, income from operations does not consider the amount of invested assets in each division On the basis of the rate of return on investment, the Road Bike Division earned 12 cents (12.0%) on each dollar of invested assets, while the Mountain Bike Division earned 15.4 cents (15.4%) on each dollar of invested assets Although the profit margin of the Road Bike Division exceeds the Mountain Bike Division (10.0% vs 7.0%), the investment turnover in the Road Bike Division is much less than the Mountain Bike Division (1.2 vs 2.2) The combination of these factors caused the Mountain Bike Division to have a higher return on investment than did the Road Bike Division Residual income can be viewed as a combination of the absolute dollar amount of income from operations generated by each division and also considers a minimum rate of return to be earned by each division On the basis of residual income, the Mountain Bike Division is the more profitable of the two divisions Prob 24–6B No When unused capacity exists in the supplying division (the Semiconductors Division), the use of the market price approach may not lead to the maximization of total company income The Semiconductors Division’s income from operations would increase by $45,240: Increase in Semiconductors Variable (Supplying) Division’s Transfer Cost Units Income from Operations = Price – per Unit × Transferred $45,240 = ($310 – $232) × 580 By selling to the Navigational Systems Division, the Semiconductors Division earns $78 per unit on these sales The Navigational Systems Division’s income from operations would increase by $70,760: Increase in Navigational Systems (Purchasing) Division’s Market Transfer Units Income from Operations = Price – Price × Transferred $70,760 = ($432 – $310) × 580 By purchasing from the Semiconductors Division, the Navigational Systems Division saves $122 per unit on its purchases Exoplex Industries Inc.’s total income from operations would increase by $116,000: Variable Increase in Exoplex Industries Income from Operations = Market Price – Cost per Unit × Units Transferred $116,000 = ($432 – $232) × 580 The increase in total company income from operations is also equal to the sum of the increases in the division incomes from operations Prob 24–6B (Continued) EXOPLEX INDUSTRIES INC Divisional Income Statements For the Year Ended December 31, 2014 Sales: 2,240 units × $396 per unit 580 units × $310 per unit 3,675 units × $590 per unit Semi- Navigational conductors Systems $ 887,040 179,800 $1,066,840 Expenses: Variable: 2,820 units × $232 per unit 580 units × $350* per unit 3,095 units × $472** per unit Fixed Total expenses Income from operations $2,168,250 $2,168,250 $ 887,040 179,800 2,168,250 $3,235,090 $ 203,000 1,460,840 325,000 $1,988,840 $ 179,410 $ 654,240 203,000 1,460,840 545,000 $2,863,080 $ 372,010 $ 654,240 220,000 $ 874,240 $ 192,600 * The 580 units are transferred in at $310 per unit plus $40 operating expenses in the division ** The remaining 3,095 units are purchased on the outside at a market price of $432 per unit plus $40 operating expenses in the division Total Prob 24–6B (Concluded) The Semiconductors Division’s income from operations would increase by $62,640: Increase in Semiconductors (Supplying) Division’s Income from Operations $62,640 Variable = Transfer Price = ($340 – Cost per Unit × Units Transferred – $232) × 580 By selling to the Navigational Systems Division, the Semiconductors Division earns $108 per unit on these sales The Navigational Systems Division’s income from operations would increase by $53,360: Increase in Navigational Systems (Purchasing) Division’s Market Transfer Units Income from Operations = Price – Price × Transferred $53,360 = ($432 – $340) × 580 By purchasing from the Semiconductors Division, the Navigational Systems Division saves $92 per unit on its purchases Exoplex Industries Inc.’s total income from operations would increase by the same amount as in (2), $116,000: Variable Increase in Ecoplex Industries Market Cost Units Income from Operations = Price – per Unit × Transferred $116,000 = ($432 – $232) × 580 The increase in total company income from operations is also equal to the sum of the increases in the division incomes from operations a Any transfer price greater than the Semiconductors Division’s variable expenses per unit of $232 but less than the market price of $432 would be acceptable b If the division managers cannot agree on a transfer price, a price of $332* would be the best compromise In this way, each division’s income from operations would increase by $58,000 * $432 – $100 = $332 $232 + $100 = $332 CASES & PROJECTS CP 24–1 This scenario is a negotiation between two divisions Dave is not behaving unethically by attempting to get a better price from the Semiconductor Division than from the market He is not behaving unethically because he refuses market price This may not seem “fair,” but price negotiation is a very typical business activity and is part of Dave’s job It would be unethical only if the X-ray Division refused to deal with the Semiconductor Division to purposefully hurt the Semiconductor Division’s performance, so that X-ray could look good in comparison This claim could only be supported if the X-ray Division’s refusal to purchase from the Semiconductor Division was economically unsound For example, maybe there are no transportation costs because the Semiconductor Division plant is on site In this case, the total cost to the X-ray Division would be less by purchasing from the Semiconductor Division Refusing to so could be the basis for claiming an ethical breach Because the X-ray Division has overall profit responsibility and authority This means that the X-ray Division has the choice of purchasing from the inside or the outside The X-ray Division should have incentives to purchase from the inside in order to maximize overall corporate income This means that the transfer price should be set below market price in order to give Dave an incentive to purchase from the Semiconductor Division Howard’s refusal to budge on market price will likely hurt the Semiconductor Division and the company as a whole If there are no alternative buyers, the Semiconductor Division should negotiate with the X-ray Division and accept a price lower than market price This produces a win-win for both divisions Thus, although neither party appears to be behaving unethically, Howard’s price position appears to be the weakest CP 24–2 The Customer Service Department head is responsible for the quantity of service, but not the source of the service (i.e., not the price) Most accountants would hold the department head responsible for the cost by transferring the cost of the brochures to the Customer Service Department, even though the price is 25% higher than could be obtained from the outside This may not seem fair, but it does control the use of internal services to some degree If there were no internal transfer price, departments would view the Publications Department as a “free good.” This would likely result in an over demand for the service, since there would be no pricing discipline on the user groups This does not mean that all is well On the contrary, the Publications Department is free to pass on its inefficiencies, since it has a captive client A possible change in policy would be to allow internal users to go to outside vendors for printing services This would have the effect of bringing the pressures of competition to the internal service group It would have to offer the service competitively, or watch its demand disappear In this way, the internal publications group would have an incentive to be as cost effective as outside printers Another possible change in policy would be to charge Publications Department services at standard cost In this way, inefficiencies in the Publications Department would not be transferred to user departments CP 24–3 The rate of return on invested assets is computed as follows: Snack Goods Income from operations………………… $ 396,000 ÷ Invested assets………………………… 2,000,000 ROI…………………………………………… 19.8% Cereal Frozen Foods $ 554,400 1,680,000 33.0% $ 420,000 1,750,000 24.0% The Cereal Division appears to be making the best use of invested assets, since its ROI is the highest Not all projects that have greater than a 19% rate of return would be accepted This is because all three divisions have an ROI that is greater than 19% Thus, any project that is accepted between the 19% minimum and their existing ROI would cause their ROI to drop This is true because of averaging There would be little incentive to accept such projects if the divisions know they are competing against each other on the basis of ROI There are two approaches to improving ROI: (1) improving the profit margin or (2) improving the investment turnover For all three divisions, the profit margin is excellent: Snack Goods Cereal Frozen Foods 18% ($396,000 ÷ $2,200,000) 22% ($554,400 ÷ $2,520,000) 20% ($420,000 ÷ $2,100,000) However, the investment turnover is slow in all three divisions The company doesn’t return many sales dollars per dollar invested in assets, as shown below Snack Goods Cereal Frozen Foods 1.1 ($2,200,000 ÷ $2,000,000) 1.5 ($2,520,000 ÷ $1,680,000) 1.2 ($2,100,000 ÷ $1,750,000) The divisions need to work on increasing revenues or reducing invested assets in order to improve ROI CP 24–4 Profit margin (Income from operations ÷ Sales)…………………………………… Investment turnover (Sales ÷ invested assets)…… Rate of return on investment (Profit margin × Investment turnover)……………………… 2012 2013 2014 15.0% 18.0% 22.0% 2012 2013 2014 2.00 1.4 0.7 2012 2013 2014 30.0% 25.2% 15.4% Anna is concerned about the Norsk Division because the return on investment appears to be deteriorating over the 2012–2014 operating periods This is happening even though the profit margin is increasing over this time period In order for this to occur, the investment turnover must be dropping, which is the case in part (2) The investment turnover is dropping faster than the profit margin is increasing, causing the rate of return on investment to drop It appears as though the Norsk Division is making very large investments in the business, but it is not able to reap the returns required to support the investment Specifically, it appears as if the revenues are not growing fast enough to support the underlying asset investment The invested asset base almost tripled, while the revenues less than doubled over the same time period The improving profit margins for each revenue dollar were not enough to make up for the revenue shortfall The division may not be able to maintain the minimum threshold rate of return on investment of 15% in the future Anna is concerned because if the trend continues it is very possible that the division’s rate of return will fall below the minimum return on investment in the future CP 24–5 Income from Operations Invested Assets Rate of Return = on Investment ROI = $4,860,000 $27,000,000 ROI = 18.0% or Rate of Return = on Investment ROI = Income from Operations Sales $4,860,000 $32,400,000 × × Sales Invested Assets $32,400,000 $27,000,000 ROI = 15.0% × 1.2 ROI = 18.0% $64,000 (8.0 × $8,000 = $64,000, where 8.0 = 18.0% – 10.0%, then rounded down to the lowest whole percentage) Rate of Return on Investment Income from Operations Invested Assets = ROI = $2,332,800 $14,400,000 ROI = 16.2% or Rate of Return on Investment = ROI = Income from Operations Sales $12,960,000 $2,332,800 × $12,960,000 × Sales Invested Assets $14,400,000 ROI = 18.0% × 0.90 ROI = 16.2% Even though the addition of the new product line would increase the overall company rate of return on investment, its addition would decrease the Specialty Products Division’s rate of return on investment from 18.0% to 17.4% ($7,192,800 ÷ $41,400,000) This decrease could negatively influence management’s evaluation of the division manager In addition, this decrease in the division’s rate of return on investment would also decrease the division manager’s bonus by approximately $8,000 (1 × $8,000, where = 18% – 17%) CP 24–5 (Concluded) Use of residual income as a performance measure and as the basis for granting bonuses would motivate division managers to accept investment opportunities that exceed a minimum rate of return If the minimum rate of return was set at 10%, the overall company average rate of return, any investment opportunity whose rate exceeded 10% would be viewed as acceptable If this performance measure had been used, the Specialty Products Division manager would have increased the division’s residual income by $892,800 through the addition of the new product line, as shown below Projected income from operations of new product line……………………… Less: Minimum amount of desired income from operations ($14,400,000 × 10%)……………………………………………………………… Residual income from new product line………………………………………… $2,332,800 1,440,000 $ 892,800 The manager’s bonus could then be calculated as a percent of residual income In this case, a bonus equal to 3% of residual income would achieve a bonus similar to the initial plan: Income from operations…………………………………………………………… Less: Minimum desired income (10% × $27,000,000)……………………… Residual income…………………………………………………………………… × Bonus percentage………………………………………………………………… $4,860,000 2,700,000 Bonus…………………………………………………………………………………… $ $2,160,000 3.0% 64,800 The new project would add $26,784 (3% × $892,800) to the bonus Income from operations with new product line……………………………… Less: Minimum desired income (10% × $14,400,000)………………………… Residual income……………………………………………………………………… × Bonus percentage……………………………………………………………… Bonus…………………………………………………………………………………… In addition, nonfinancial performance indicators about product quality and customer satisfaction can be used to supplement the financial numbers $2,332,800 1,440,000 $ 892,800 3.0% $ 26,784 .. .CHAPTER 24 Performance Evaluation for Decentralized Operations PRACTICE EXERCISES PE 24 1A $326,000 over budget ($252,000 + $74,000) PE 24 1B $250,000 under budget ($198,000 + $52,000) PE 24 2A... Budget Actual Over Budget $192 ,240 (a) 153,216 246 ,600 $195,072 (b) 155,232 245 ,952 $2,832 (c) 2,016 $592,056 (d) $596,256 (e) $4,848 (f) Under Budget $648 $648 Ex 24 1 (Concluded) MAQUIRE COMPANY... and light Maintenance b $ 47,952 125,280 6,912 12,096 $192 ,240 Actual $ 49,200 124, 416 8,208 13 ,248 $195,072 Over Budget Under Budget $1 ,248 $864 1,296 1,152 $3,696 $864 MEMO To: Holly Keller, Vice